Production location of multinational firms under transfer pricing: the impact of the arm's length principle

When multinational enterprises (MNEs) separate the geographical location of affiliates, they can shift profits between the affiliates by manipulating intra-firm prices of inputs. We show that if the international tax difference between the parent and the host countries is large, MNEs choose to separately locate their affiliates in the two countries. We also investigate the impact of the arm's length principle (ALP) on the location choice, which requires that the intra-firm price of inputs should be set equal to the price of similar inputs for the independent downstream firms. The ALP may change the location choice of MNEs, bringing smaller tax revenues to the host country, but greater revenues globally.